Using the Market Price to Calculate Implicit Return Using the H-Model Dividend Discount Model

The dividend discount model and other discounted cash flow approached define the value of a stock as a function of the current cash flow, growth and a required rate of return. Normally these models are used to derive a valuation, which is then compared to the current stock price to determine whether the stock is “overvalued” or “undervalued.” The determination will be affected by the assumptions made regarding required return and growth.

An alternative is to reverse the model and use the current stock price to determine the average assumptions being implicitly made by investors. For example, consider a stock with a $20.00 current share price and $1.00 in expected annual dividends. The consensus long-term growth estimate is 6%, and the investor believes this growth rate reflects the typical belief of market participants. I showed how to do this using the Gordon growth model here.

But what about more complicated models?  Back in August I used a two-stage H-model to estimate the value of Rockwell Automation, and came up with a potential value of $91.59, which was much higher than the $69.00 share price. The model was based on a required return of 10%. Alternatively, we can figure out what the return would be based on the $69 share price (assuming of course that the other inputs were correct.)

To estimate the required return from the H-Model, the formula can be rearranged as r = (D0/P0)[(1 + gl) + H(gs - gl)] + gl where D0/P0 is the current dividend yield, gl is the terminal growth rate, gs is the initial high growth rate and H is the half-life of the high growth. In our example:

D0 = $1.16

P0 = $69.00

gl = 7%

gs = 36%

H = 5

So r = ($1.16/$69)[1.07 + 5(0.36 - 0.07)] + .07 = 0.017(1.07 + 1.45) + 0.07 = 0.43 + 0.07 = 11.3%.

For more information, see all articles on: Investing in Stocks, Valuation

See also:
  • Using the Market Price to Calculate Implicit Return in a Multi-Stage Dividend Discount Model
  • A Three Stage H-Model Dividend Discount Model
  • Using the Single Stage Residual Model to Calculate Implied Expected Growth
  • Estimating the Required Rate of Return Implicit in the Share Price
  • Valuing a Non-Dividend Paying Stock Using the Dividend Discount Model
  • Technical Analysis Explained : The Successful Investor's Guide to Spotting Investment Trends and Turning Points

    The Intelligent Investor: The Classic Text on Value Investing

    Financial Statement Analysis: A Practitioner's Guide, 3rd Edition

    Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)

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